UNIT-II FOREIGN

EXCHANGE MARKET
DISTINCTIVE FEATURES AND TYPES,
MAJOR PARTICIPANTS, PARTICIPANTS
IN FOREIGN EXCHANGE MARKET
• Foreign exchange market is a market for buying and
selling foreign currencies. It is a global online network
where currencies of different countries are bought and
sold. The foreign exchange market determines the
exchange rate for currencies around the world. This
market is also termed as Currency, FX, or forex market.
Its structure comprises of individuals, firms, commercial
banks, the central banks, importers and exporters,
investors, brokers, immigrants, tourists. The foreign
exchange market is a system and does not have any
physical location.
• This market operates 24 hours a day from 5 p.m. EST on Sunday to
4 p.m. EST on Friday. It is the world’s most liquid financial market.
The trading of currencies in the foreign exchange market always
takes place in pairs so that the value of one of the currencies in that
pair is relative to the value of others. This global market has two
tiers. The first one is known as the interbank market and the second
one is known as the over-the-counter market.
• The interbank market is the one where bigger banks trade and
exchange currencies with each other. Over the counter market is the
one where individuals and companies trade and has become a very
popular market as now there are several companies that provide
online trading platforms.
FEATURES OF FOREIGN EXCHANGE MARKET
• High Liquidity
• The foreign exchange market is the most liquid
financial market in the world. It involves the trading
of various currencies across the globe. All traders in
this market are free to buy or sell currencies anytime
as per their choice. They are free to exchange
currencies without prices of currencies being traded
getting affected. Currencies prices remain the same
both at the time of order placed and executed thereby
enabling to earn the expected prices.
• Market Transparency
• Trader in the foreign exchange market has full
access to all market data and information. They
can easily monitor different countries’
currencies price fluctuations through real-time
portfolio and account tracking without the need
of a broker. All this information helps in
making better trading decisions and control
over investments.
• Dynamic Market
• The foreign exchange market is a dynamic
market. In these markets, currency values
change every second and hour. These values
changes in accordance with changing forces of
demand and supply which also helps in
determining the exchange rates. Due to its fast-
changing character, this market is termed as the
perfect market to trade.
• Operates 24 Hours
• Foreign exchange markets function 24 hours a
day. It provides a platform where currencies
can be traded anytime by traders. It provides a
convenient time to all necessary adjustments
when and wherever needed.
• Lower Trading Cost
• The forex market has a very low trading cost. In
these markets, there are no commissions like in case
of any other investments. Any difference between
buying and selling prices of currencies is the only
cost of trading in the forex market. As there are low
costs then the possibility of incurring losses is also
minimum thereby making it possible for small
investors to make good profit from trading.
• Dollar Most Widely Traded
• The dollar is the most dominant currency in
the foreign exchange market. This currency is
paired with every country’s currency being
traded in the forex market. In a major
proportion of transactions every day, the dollar
is one of the two currencies being traded.
• Spot Market
• The spot market is a market in which quick transactions
regarding currency exchange takes place. Here buying and
selling of currencies is done for immediate delivery.
Immediate payment at the current exchange rate is
provided to buyers and sellers in the spot market. The
Trade-in spot market takes one or two days for settlement
of transactions and allows traders to open to the volatility
of the currency market. This can increase or decrease price,
between agreement and trade. Spot market almost accounts
for one-third of currency exchange transactions. 
• Forward Market
• It is a market in which transactions are done for doing trade
at some future date. Here both payment and delivery are
done at future date at agreed exchange rate also termed as
the forward exchange rate. The contract is made between
buyers and sellers for sale and purchase of currency after 90
days. Forward contracts are non-standardized contracts. It
means that these contracts can be customized or tailored
according to the needs of participants. At the time of
entering the contract, no security deposit is required as no
money exchange takes place.
• Future Market
• Future market is also similar to the forward market. In
future market, contract are made between buyers and
sellers to do trade in future. All payments and delivery in
this market are done at decided exchange rate which is
also termed as future rate. Whereas future contracts are
standardized contracts and cannot be customized. These
contracts are standardized in terms of their date, features,
size, and cannot be negotiated. Trading on future market is
centralized on stock exchanges like BSE, NSE, and
KOSPI. 
• Swaps Market
• Swap market is one where transactions for simultaneous
lending and borrowing of two different currencies are done
between investors. It is a contract between two or more
parties for exchanging cash flows on the basis of a
predetermined notional principal amount. In the swap market,
there two types of swap transactions done that are currency
swap and interest swap. Currency swap is an exchange of a
fixed currency rates of one country with a floating currency
rate of another country. Interest swap means the exchange of
floating interest rate with a fixed rate of interest.
• Options Market
• The options market is one where transactions are done for
exchanging one currency with at agreed rate and on a
specified date. Under the option contract, it is an option
for an investor to convert the currency but not under any
obligation to do so. The buyer of the option has the right
but not an obligation to sell or purchase the underlying
currency in the contract at future date and at agreed rate.
Options are of two types that is call option and put option.
A put option gives the right to sell and call option gives
the right to buy.
 Major Participants in Forex Market  

• The term “forex market main participants” are

the parties who make the currencies prices
move. They are the ones who make the trade
setups, because over 80% of the forex market
transactions are done by them. Retail traders
are responsible for less than 20% of the
transactions. In general, what retail traders do
has almost no impact on the price movements.
• Some of the biggest stake holders in forex trade are the central
banks and the Government. It is indeed overwhelming to think
how a few ticks this way or that way can actually alter the
money supply globally or the vice versa, how the money
supply of one country can literally have a bearing on the global
currency movement. Thus it becomes really important to all
those who are contemplating trying out the Forex market,
understand the players they would be rubbing shoulders with
and competing to get a piece of the profit pie. Here is a blow
by blow account of the top players in the forex world and the
role they play in deciding the global currency trends.
• Central Banks
• Probably the most influential players in the forex world are the
central banks and the Governments they represent. More often
than not you see Central Banks world executing policy matters
in line with the existing Government’s political ideology, the
economic demands and the steps necessary to keep the
economic situation of a country in good state. The central
bank’s monetary policy generally outlines the particular
country’s vision for growth, how they are tackling issues like
inflation/deflation and stance on interest rates. The Central
Bank’s stance on interest rates is crucial as this is what
determines the money supply for a country and its currency
rate globally.
• While many countries have strict Govt intervention
while some Central Banks have relative
independence in their day to day function. However
they continue to be a core player in the forex market
essentially to execute the Govt’s key monetary goals
by maintaining the foreign reserve volumes. These
concerns also make them very active stakeholders in
the world of forex trades and their deep pockets
ensure any move by any of these banks can bring
about significant change.
• Unlike retail traders who trade to make profit,
central banks don’t care about profit and loss in
many of the transactions they perform, because
there are some different purposes behind what they
do on the forex market. For example, Bank of Japan
(BOJ) has to keep the value of Japanese Yen always
low, because Japan’s economy is dependent on the
export of the Japanese products, and the other
countries will have less tendency to order their
products if the value of Japanese Yen goes high.
• When the JPY value goes up, BOJ buys the other
countries currencies against JPY (or sell JPY against the
other currencies) to lower the JPY value. There is no
doubt that they will lose a lot in this process, but they
don’t care, because it is more important for them to keep
the JPY value always low. This causes the other countries
to keep on buying Japanese products, and so the country
will make profit in long term. So, they handle losses in
these transactions to keep their industries working. Not
everybody trades for profit like what you do 
• Financial Institutions
• Apart from the Government along with the Central
Banks, another major player in the forex market are
the Banks & Financial institutions. One of the major
participants in forex transactions, banks are involved
in foreign exchange transactions for a myriad of
reasons. Whether it is foreign currency for business
transactions, tours or personal use, banks deal with a
huge amount of foreign exchange at any given time.
One of the core players of the interbank market, they
provide the key liquidity push in the forex market.
• Financial institutions also include different
kinds of individual investors as well as
investment funds. Pension funds, hedge funds
and money managers also form the core
elements of the inter-bank market. The huge
traffic of foreign exchange also ensure a strong
pricing power for these institutions.
• Hedgers
• From banks we shift to some of the biggest clients that
these banks cater to. Any big firm that is doing business
internationally or is dealing with international clients will
require tackling currency volatility. Be it the booming IT
industry in countries like India or the energy business
globally, just about nobody enjoys the currency fluctuation
risk. For most multinational companies, this uncertainty is
by far the key area of concern and many are working
overnight to ease out the pressure as a result of this.
• Here is an example to simplify the implications.
Let’s assume a German company ordered a Japanese
company to deliver some equipment that they make
but supposing it is a long-term order and most of the
payment has to be made after a year. The German
company can never be sure that exact amount of Yen
that they might have to pay after the end of the year
and what kind of fluctuation might be seen in the
some equipment from a Japanese manufacturer that
needs to be paid in Yen one year from now.
• Since the exchange rate can fluctuate in any
direction over the course of a year, the risk of the
exact Euro outgo for the German firm is a major
factor to look out. Therefore it will help if the
company can hedge some Euro against the Yen at
the current yen rate. This will be like insurance for
the company against any future loss due to a major
price fluctuation. These hedging strategies are
devised to lock  in specific exchange rate for future
dealings.
• Speculators
• Now there is another set of key players in the
forex market. They play a key role in
predicting trends, attempt to profit from these
predictions and the fluctuation in currency rate
is what they make living out of. They bet on
potential trends in future and walk the
tightrope of daily fluctuation in exchange rates
globally to expand their profits.
• Perhaps one of the most famous speculators is
George Soros. His shorts on the pound that
earned him a billion dollars in less than a
month are one of the most famous currency
trades till date. The other extreme is of course
Nick Leeson. He was a trader with the Barings
Bank, England. He lost over a billion dollar in
speculative positions on Yen futures and
resulted in the actual collapse of the company.
• Not just individuals but many hedge funds also get
involved in speculative action. Very often these
hedge funds employ risky strategies to bring about
higher returns. They normally deal with very large
amounts of money and given their speculative
position they can at times have a major impact on
the global currency move. The Asian currency
crisis in the 1990s is often seen as one perpetrated
by speculative action of hedge funds.
• Retail Participants
• The last but not the least important are the retail
participants who comprise a key link in the complex
labyrinth of the financial market. You have
individual forex traders and corporations who are
involved in regular trade of foreign currencies for
personal gains and business purposes. Though they
do not have a major role in deciding the trend but are
some of the major players in whatever trends take
shape eventually.
• Thus this is a broad outline of all the leading
participants who play a crucial role in the
successful functioning of the forex market.
Each of these players is integral to the effective
functioning of the overall forex market and
together they shape the structure of currency
movement globally. As a trader in the forex
world, it is important that you have a broad
view of all these different types of stakeholders.
• That will enable you to take a constructive call
on the market and also help you predict the
possible outcome of a key news matter better.
Another important fact is an understanding of
the key market participants in the forex market
also gives you a bird’s eye perspective on
straight forward interpretation on forex
strategies.
• Who are the participants in the foreign
exchange market?
• The foreign exchange market is the most liquid
financial market in the world. Traders include
governments and central banks, commercial
banks, other institutional investors and
financial institutions, currency speculators,
other commercial corporations, and individuals.
Participants of Foreign Exchange Market

• The main participants in the foreign exchange market include

foreign exchange dealers, financial and non-financial customers,
central banks and brokers.
• Participant # 1. Foreign Exchange Dealers:
• Most commercial banks in the United States customarily have
bought and sold foreign exchange for their customers as one of
their standard financial services. But beginning at a very early
stage in the development of the over-the-counter market, a small
number of large commercial banks operating in New York and
other U.S. money centers took on foreign exchange trading as a
major business activity. They operated for corporate and other
customers, serving as intermediaries and market makers.
• In this capacity, they transacted business as
correspondents for many other commercial
banks throughout the country, while also
buying and selling foreign exchange for their
own accounts. These major dealer banks found
it useful to trade with each other frequently, as
they sought to find buyers and sellers and to
manage their positions. This group developed
into an inter-bank market for foreign exchange.
• During the past 25 years, some investment banking firms and
other financial institutions have become emulators and direct
competitors of the commercial banks as dealers in the over-the-
counter market. They now also serve as major dealers, executing
transactions that previously would have been handled only by the
large commercial banks, and providing foreign exchange services
to a variety of customers in competition with the dealer banks.
• They are now part of the network of foreign exchange dealers that
constitutes the U.S. segment of the foreign exchange market.
Although it is still called the “inter-bank” market in foreign
exchange, it is more accurately an “inter dealer” market.
• Of the 93 reporting dealers in 1998, 82 were commercial banks, and 11
were investment banks or insurance firms. All of the large U.S. money
center banks are active dealers. Most of the 93 institutions are located in
New York, but a number of them are based in Boston, Chicago, San
Francisco, and other U.S. financial centers. Many of the dealer
institutions have outlets in other countries as well as in the United States.
• Included in the group are a substantial number of U.S. branches and
subsidiaries of major foreign banks —banks from Japan, the United
Kingdom, Germany, France, Switzerland, and elsewhere. Many of these
branches and agencies specialize in dealing in the home currency of their
parent bank. A substantial share of the foreign exchange activity of the
dealers in the United States is done by these U.S. branches and
subsidiaries of foreign banks.
• Participant # 2. Financial and Non-Financial Customers:
• According to the 1998 survey, 49 percent of the foreign exchange trading activity
in the over-the-counter market represented “inter dealer” transactions, of the
remaining 51 percent of total foreign exchange transactions, financial (non-
dealer) customers accounted for 31 percent, and non-financial customers 20
percent.
• The range of financial and non-financial customers includes such counterparties
as- smaller commercial banks and investment banks that do not act as major
dealers, firms and corporations that are buying or selling foreign exchange
because they are in the process of buying or selling something else (a product, a
service, or a financial asset), managers of money funds, mutual funds, hedge
funds, and pension funds; and even high net worth individuals. For such
intermediaries and end-users, the foreign exchange transaction is part of the
payments process —that is, a means of completing some commercial,
investment, speculative, or hedging activity.
• Institutional investors, insurance companies, pension
funds, mutual funds, hedge funds, and other investment
funds have, in recent years, become major participants in
the foreign exchange markets. Many of these investors
have begun to take a more global approach to portfolio
management. Even though these institutions in the
aggregate still hold only a relatively small proportion (5 to
10 percent) of their investments in foreign currency
denominated assets, the amounts these institutions control
are so large that they have become key players in the
foreign exchange market.
• In the United States, for example, mutual
funds have grown to more than $5 trillion in
total assets, pension funds are close to $3
trillion, and insurance companies about $21/2
trillion. The hedge funds, though far smaller in
total assets, also are able to play an important
role, given their frequent use of high leverage
and, in many cases, their investors’ financial
strength and higher tolerance for risk.
• Given the large magnitudes of these institutions’ assets, even a
modest shift in emphasis toward foreign investment can mean
large increases in foreign exchange transactions. In addition,
there has been a tendency among many funds managers
worldwide to manage their investments much more actively,
and with greater focus on short-term results. Rapid growth in
derivatives and the development of new financial instruments
also have fostered international investment.
• Reflecting these developments, portfolio investment has come
to play a very prominent role in the foreign exchange market
and accounts for a large share of foreign exchange market
activity. The role of portfolio investment may continue to
grow rapidly, as fund managers and investors increase the
level of funds invested abroad.
• Participant # 3. Central Banks:
• All central banks participate in their nations’ foreign exchange
markets to some degree, and their operations can be of great
importance to those markets. But central banks differ, not only
in the extent of their participation, but also in the manner and
purposes of their involvement.
• Intervention operations designed to influence foreign
exchange market conditions or the exchange rate represent a
critically important aspect of central banks’ foreign exchange
transactions. However, the intervention practices of individual
central banks differ greatly with respect to objectives,
approaches, amounts, and tactics. Unlike the days of the
Bretton Woods par value system (before 1971), nations are
now free, within broad rules of the IMF, to choose the
• The United States and many other developed and developing nations have
chosen an “independently floating” regime, providing for a considerable
degree of flexibility in their exchange rates. But a large number of countries
continue to peg their currencies, either to the U.S. dollar or some other
currency, or to a currency basket or a currency composite, or have chosen
some other regime to limit or manage flexibility of the home currency .The
choice of exchange rate regime determines the basic framework within
which each central bank carries out its intervention activities.
• Foreign exchange market intervention is not the only reason central banks
buy and sell foreign currencies. Many central banks serve as their
government’s principal international banker, and handle most, and in some
cases all, foreign exchange transactions for the government as well as for
other public sector enterprises, such as the post office, electric power
utilities, and nationalized airline or railroad.
• Consequently, even without its own intervention operations,
a central bank may be operating in the foreign exchange
market in order to acquire or dispose’ of foreign currencies
for some government procurement or investment purpose.
• A central bank also may seek to accumulate, reallocate
among currencies, or reduce its foreign exchange reserve
balances. It may be in the market as agent for another central
bank, using that other central bank’s resources to assist it in
influencing that nation’s exchange rate. Alternatively, it
might be assisting another central bank in acquiring foreign
currencies needed for the other central bank’s.
• Thus, for example, the Foreign Exchange Desk of the
Federal Reserve Bank of New York engages in
intervention operations only occasionally. But it usually
is in the market every day, buying and selling foreign
currencies, often in modest amounts, for its “customers”
(i.e., other central banks, some U.S. agencies, and
international institutions). This “customer” business
provides a useful service to other central banks or
agencies, while also enabling the Desk to stay in close
touch with the market for the currencies being traded.
• Participant # 4. Brokers:
• In the Over-the-Counter Market:
• The role of a broker in the OTC market is to bring together a buyer
and a seller in return for a fee or commission. Whereas a “dealer”
acts as principal in a transaction and may take one side of a trade
for his firm’s account, thus committing the firm’s capital, a “broker”
is an intermediary who acts as agent for one or both parties in the
transaction and, in principle, does not commit capital. The dealer
hopes to find the- other side to the transaction and earn a spread by
closing out the position in a subsequent trade with another party,
while the broker relies on the commission received for the service
provided (i.e. ,bringing the buyer and seller together).
• Brokers do not take positions or face the risk of holding
an inventory of currency balances subject to exchange
rate fluctuations. In over-the- counter trading, the activity
of brokers is confined to the dealers market. Brokers,
including “voice” brokers located in the United States
and abroad, as well as electronic brokerage systems,
handle about one quarter of all U.S. foreign exchange
transactions in the OTC market. The remaining three-
quarters take the form of “direct dealing” between
dealers and other institutions in the market.
• The share of business going through brokers varies in different national
markets, because of differences in market structure and tradition. Earlier
surveys showed brokers’ share averages as low as 10-15 percent in some
markets (Switzerland and South Africa) and as high as 45-50 percent in
others (France, Netherlands, and Ireland).
• Foreign exchange brokerage is a highly competitive field and the brokers
must provide service of high quality in order to make a profit. Although
some tend to specialize in particular currencies, they are all rivals for the
same business in the inter- dealer market. Not only do brokers compete
among themselves for broker business — voice brokers against each other,
against voice brokers located abroad, and against electronic broking
systems—but the broker community as a whole competes against banks
and other dealer institutions that have the option of dealing directly with
each other, both in their local- markets and abroad, and avoiding the
brokers and the brokers’ fees.
• (a) Voice Brokers:
• Skill in carrying out operations for customers and the degree of
customers’ confidence determine a voice broker’s success. To
perform their function, brokers must stay in close touch with a
large number of dealers and know the rates at which market
participants are prepared to buy and sell. With 93 active dealers
in New York and a much larger number in London, that can be
a formidable task, particularly at times of intense activity and
volatile rate movements. Information is the essential ingredient
of the foreign exchange market and the player with the latest,
complete, and most reliable information holds the best cards.
• As one channel, many voice brokers have open
telephone lines to many trading desks, so that a bank
trader dealing in, say, sterling, can hear over squawk
boxes continuous oral reports of the activity of
brokers in that currency, the condition of the market,
the number of transactions occurring, and the rates
at which trading is taking place, though traders do
not hear the names of the two banks in the
transaction or the specific amounts of the trade.
• (b) Automated Order-Matching, or Electronic Broking Systems:
• Until 1992, all brokered business in the U.S. OTC market was handled by voice
brokers. But during the past few years, electronic broker systems (or automated
order matching systems) have gained a significant share of the market for spot
transactions. The two electronic broking systems currently operating in the
United States are Electronic Brokerage Systems, or EBS, and Reuters 2000-2. In
the 1998 survey, electronic broking accounted for 13 percent of total market
volume in the United States, more than double its market share three years
earlier.
• In the brokers market, 57 percent of turnover is now conducted through order-
matching systems, compared with 18 percent in 1995. With these electronic
systems, traders can see on their screens the bid and offer rates that are being
quoted by potential counterparties acceptable to that trader’s institution (as well
as quotes available in the market more broadly), match an order, and make the
deal electronically ,with back offices receiving proper notification.
• The electronic broking systems are regarded as fast and reliable.
Like a voice broker, they offer a degree of anonymity. The
counterparty is not known until the deal is struck, and then only
to the other counterparty.
• The fees charged for this computerized service are regarded as
competitive. The automated systems are already widely used for
certain standardized operations in the spot market, particularly
for smaller-sized transactions in the most widely traded currency
pairs. Many market observers expect these electronic broking or
order matching systems to expand their activities much further
and to develop systems to cover additional products, to the
competitive disadvantage, in particular, of the voice brokers.
• (c) In the Exchange-Traded Market:
• In the exchange-traded segment of the market, which covers currency
futures and exchange traded currency options, the institutional structure
and the role of brokers are different from those in the OTC market.
• In the exchanges, orders from customers are transmitted to a floor broker.
The floor broker then tries to execute the order on the floor of the
exchange (by open outcry), either with another floor broker or with one
of the floor traders, also called “locals,” who are members of the
exchange on the trading floor, executing trades or themselves.
• Each completed deal is channeled through the clearing house of that
particular exchange by a learning member firm. A participant that is not a
clearing member firm must have its trades cleared by a clearing member.
• The clearinghouse guarantees the performance of both
parties, assuring that the long side of every short position
will be met, and that the short side of every long position
will be met. This requires (unlike in the OTC Market)
payment of initial and maintenance margins to the
clearinghouse (by buyers and sellers of futures and by
writers, but not holders, of options). In addition, there is
daily marking to market and settlement. Thus, frequent
payments to (and receipts from) brokers and clearing
members may be called for by customers to meet these
daily settlements.